Mister In-Between is 100% Sure

60 MINUTES: "Can you act quickly enough to prevent inflation from getting
out of control?"

BERNANKE: "We could raise interest rates in 15 minutes if we have to. So,
there really is no problem with raising rates, tightening monetary policy,
slowing the economy, reducing inflation, at the appropriate time. Now,
that time is not now."

60 MINUTES: "You have what degree of confidence in your ability to control
this?"

BERNANKE: "One hundred percent."

"60 Minutes," December 5, 2010

Federal Reserve Chairman Ben Bernanke's lecture series at George Washington
University is most unfortunate. Whether he believes what he is saying or not,
he is a punch bowl of contaminated mead.

The first instinct, at least here, is to let it pass. Wolfgang Pauli's exasperation
came to mind when reading capsules of the Fed chairman's lectures. Where to
start? Where to end? To what purpose?

The last, first. The purpose here is to throw light on a mind so inadequately
prepared, yet 100% sure, of extracting the world from an unprecedented gamble.
The gamble is Bernanke's dry run of his professorial emissions. The professor's
chalkboard smog is the basis for his current policy. Real interest rates are
below zero and the central bank is creating immeasurable quantities of dollar
bills that Bernanke is sure will right the U.S. economy while not sacrificing
his wandering price stability.

"Immeasurable," since Bernanke and other members of the FOMC do not know when
they will stop. Listen to their contradictory speeches. We are not witnessing
the introduction of an economic theory. We are chips in a poker championship.

Rather than address my stated purpose by rehabilitating either Bernanke's
disfigured explanation of the 1930s or how the gold standard functioned -
the disentanglements alone would require pages - we will look at one of his
simpler claims. Following is an effort in pointillism.

Two of the man's characteristics will be addressed in what follows. First,
his inability to anticipate. Second, his limited understanding of the past,
which is a cause of his inability to anticipate.

On March 22, 2012, the Fed chairman told students at George Washington University: "The
decline in house prices by itself was not obviously a major threat." To clarify
this statement, Bernanke was responding to a question about the housing bubble.
He was addressing the aftermath, when prices fell. He concluded that falling
house prices, by themselves, were not obviously a major threat to the economy,
and, presumably to the financial system that serves to finance that economy.

Wolfgang Pauli would probably agree that Bernanke's attempt at clarification
is neither right nor wrong. It is meaningless. As a general statement, rising
house prices do not constitute a bubble. Nor, are falling house prices synonymous
with a crash. The most important distinction is the degree of borrowing that
contributed to the upswing. Of the recent housing enthusiasm, Panderer
to Power made this clear. During the Greenspan-Bernanke chairmanship,
the U.S. did not experience a housing crash, it suffered a mortgage collapse.

Bernanke claims the "decline in house prices by itself was not obviously a
major threat [before it crashed in 2007 - FJS]." The man was either unaware
of how housing finance was conducted in the U.S. during bubble years or considered
it irrelevant.

As a Federal Reserve Board member (from 2002 to the present day, with a short
sabbatical as economic adviser to President Bush) Bernanke completely missed
the coming mortgage collapse. He admits that. He also claims nobody else saw
it coming. The Federal Reserve chairman, like all cloistered academic economists,
would never condescend to read a newspaper, so would not see what the average
bartender knew. Anyone reading the following knew that houses were the new
momentum trade that replaced the dot.com fandango:

August 8, 2001, Wall Street Journal, Headline: "'Subprime' Could Be
Bad News for Banks: Riskier Loans, Now Prevalent in Industry, Show Problems" We
read: "American Express so far this year has taken more than $1 billion in
junk-bond-related write-downs."

August 31, 2001, Wall Street Journal, Headline: "Is Appraisal Process
Skewing Home Values?" We read: "Appraisers are frequently encouraged to fudge
the numbers." From Mark Vitner, an economist at First Union Corp., the "upward
spiral of prices becomes self-reinforcing." The Wall Street Journal reporter
concluded: "Some believe home prices are beginning to act like technology
stocks. Mr. Vitner says they're moving up so fast that any value seems reasonable."

September 3, 2001, Forbes magazine, Cover: "WHAT IF HOME PRICES CRASH?" Picture
on the cover of a young couple: "Their house lost $1 million in value. It
could happen to you. It could happen to a lot of people and wreck the economy." We
learn that their house - in Palo Alto, California, fell in value from $2 million
to $1million over 7 months.

March 28, 2002, Economist, cover story: "The houses that saved the
world" We read: "...homes have kept the world economy aloft."

April 18, 2002, Wall Street Journal,Headline: "Reverse-Mortgage Rules
May be Loosened" We read: "Congress is looking to loosen the rules on reverse
mortgages. The move could allow millions of seniors to extract far more money
from their homes than is possible - though to some critics that isn't necessarily
a good thing."

July 22, 2002, Business Wire, Reporting on recent testimony of Federal
Reserve Chairman Alan Greenspan: "We've looked at the bubble question and
we've concluded that it is most unlikely."

July 22, 2002, Business Wire, Same article, quoting National Association
of Home Builders Chief Economist David Seiders: "The time has come to put
this issue to rest. The nation's home builders have said it, the Realtors(R)
have said it, and now Alan Greenspan has said it once again, in no uncertain
terms: there is no such thing as a current or impending house price bubble."

The web of interests was obvious by 2002. Princeton professor Ben S. Bernanke
joined the Federal Reserve Board on August 5, 2002.

At that point, the question that occupied the alert observer was how long
the web could keep spinning. When Ben Bernanke joined the Federal Reserve
Board in 2002, he dragged his "zero-bound" twaddle to FOMC meetings, and soon
enough the Fed was launching helicopters, suffering conundrums, and holding
real rates below zero.

And now, on March 23, 2012, the man running the Federal Reserve, who not only
could not see the housing bubble but can not rotate his mind to believe anyone
else did, is "100% sure" he will extract the world from a money-printing escapade
that has increased central bank balance sheets from about $4 trillion in 2008
to about $13 trillion in 2013 (these numbers are from memory), and not destabilize
the world price structure.

The second characteristic of the Bernanke mind to be addressed is his historical
illiteracy. Given the quoted statement made to George Washington University
students, he does not know how financing contributed to previous housing booms
and busts. We will look at one state, where, it is 100% clear that fly-by-night
finance was the leading cause of post-binge trauma.

The population of Los Angeles rose from 10,000 in 1880 to 50,000 in 1890.
Yet, a severe real estate bust wiped out most of the wealth in 1887 and 1888.
David Starr Jordan described the boom and bust in California and the Californians: "[A]lmost
every bluff along the coast, from Los Angeles to San Diego and beyond was
staked out in town lots." He continued: "Every resident bought lots, all the
lots he could hold. The tourist took his hand in speculation. [My italics
- FJS] Corner lots in San Diego, Del Mar, Azusa, Redlands, Riverside, Pasadena,
anywhere brought fabulous prices. A village was laid out in the uninhabited
bed of a mountain torrent, and men stood in the streets in Los Angeles...
all night long, to wait their turn in buying lots. Land, worthless and inaccessible,
barren cliffs' river-wash, sand hills, cactus deserts' sinks of alkali, everything
met with ready sale. The belief that Southern California would be one great
city was universal. [The far-sighted investor was correct, but lost his shirt
in 1888. - FJS] The desire to buy became a mania. 'Millionaires of a day,'
even the shrewdest lost their heads, and the boom ended, as such booms always
end in utter collapse."

"Tourists" includes speculators from the east, north, and south, drawn to
the latest California gold rush. It was not only Los Angeles. Kansas City
crested in 1888, Chicago in 1890, and the country as a whole in 1888-1889.
When everyone from Alan Greenspan to Standard & Poor's swatted down bubble
concerns ("real estate slumps are local affairs"), the nation's participation
in regional manias was not considered. Other significant features of L.A.
in the 1880s were a price collapse when the population rose 500%, and, no
central bank existed to prod the insolvency.

Los Angeles boomed in the 1920s as did its real estate. The sun, movies and
discovery of oil in Los Angeles County encouraged wagon trains from the East.
Across the country, speculators were drawn to real estate between 1920 and
1925.

In Ten Years on Wall Street, Barnie Winkelman set the stage: "The shortage
of offices, apartment houses, and dwellings which had resulted from the protracted
holiday from construction during the World War, had brought on a wave of building.
In its wake came the flotation of real-estate bonds running into hundreds
of millions, financing practices which embodied the worst practices of Wall
Street bond flotation, and saddled millions of school teachers, physicians,
widows, the aged and infirm, who had forsworn stocks on the Exchange and railroad
and industrial bonds, with realty obligations infinitely less substantial.
On back of these over-appraised real estate liens were second mortgage loans
held by individuals and building and loan associations. The collapse of many
building and loan associations in 1925 marked the gradual recession in real
estate prices....."

That's enough. Upon reading "financing practices which embodied the worst
practices of Wall Street," you knew how this would turn out. The Florida land
boom and bust (1926) is synonymous with the decade. Today, the degree of national
participation is not so celebrated. Nor, that the residential real estate
building boom across the country generally peaked at the same time. Real spending
on new, private, non-farm housing fell 89% from its peak in 1926 to its trough
in 1933.

A chart of Los Angeles County residential real estate activity points nearly
straight up between 1920 and 1925. (Lewis A. Maverick, "Cycles in Real Estate
Activity: Los Angeles County") Chicago also achieved its personal best in
1925, though New York was just warming up, particularly in the commercial
area, rising until 1930. (The average price of office-building bonds fell
from $1,000 upon issue to $187 in 1932.) Even with the booming Southern California
economy, the graph of L.A. County real estate activity falls from 1926 through
1930, and presumably beyond.

The 1970s was a boom time for houses, but much of those gains were lost to
inflation. House prices rose 8.0% a year during the decade, while the consumer
price index rose at a 7.4% rate. (Nationally, house prices rose 17.7% in the
first nine months of 1979; the CPI passed 16% that year.)

California was a star performer where house prices rose 20% in 1974, 17% in
1975, and 28% in 1976. (The standard belief that lower interest rates will
solve house troubles is taken for granted. The prime rate rose from 9.50%
in early 1974 to 15.50% in late 1979.) William Greider wrote in Secrets
of the Temple: "People were not buying houses to live in or even as long-term
investments. They were buying homes in order to sell them."A builder in Contra
Costa County (California) found that 60% of his sales were to speculators.
In San Diego alone the number of realtors doubled between 1975 and 1979. A
condominium bought in Irvine Ranch (California) for $87,000 was sold for $117,000
- two weeks before the mortgage closing was completed. We need not tarry here;
this is so old that it's new.

The 1970s boom was followed by a bust, but not of today's dimensions. One
reason being that mortgage lending did not rocket off its moorings, either
in terms offered or in the variety of lenders. In the early 1980s, homeowners'
average equity (nationally) equaled 70% of house market values.

The 1980s savings-and-loan catastrophe left the Southern California mortgage
market in a miserable state. The S&L boom was the product of relaxed regulations,
funny finance, and dreadful accounting - all of which should have been evident
to Ben S. Bernanke in 2002. According to the San Diego Union Tribune: "When
the bubble burst in 1989, some home prices fell 10 to 20 percent, while the
price of raw land dropped even more. End result: As real estate analysts see
it, local developers, builders, bankers, planners and home buyers all made
a fatal assumption three years ago. [They splurged near the peak. - FJS] ....
[I]n 1987, 1988 and 1989 prices soar[ed], doubling from $89,000 to $198,000.
The average price now stands at $95,000 per acre and [a market analyst] doesn't
think it will recover even half its former, inflated value any time soon."

The market analyst may have been correct if not for L. William Seidman. He
headed the Resolution Trust Corporation (RTC), which closed the bad banks
and disposed of the busted real estate at fire sale prices. We should have
followed the same blueprint today, but have done exactly the opposite. Thus,
instead of clearing the market, we have millions of houses floating in limbo.

Upon completion of his assignment, Seidman shut down this federal agency.
He was very critical of Bernanke's (and Paulson's) TARP (Troubled Asset Relief
Program). Comparing TARP to the RTC: "What we did, we took over the bank,
nationalized it, fired the management, took out the bad assets and put a good
bank back in the system." Comparing Seidman's purging of bad banks to Bernanke's
handling of the Too-Big-to-Fail Banks (which hold much larger quantities of
assets today than in 2008), is, again, cause to believe Bernanke has no idea
what he is doing.

Like Sisyphus, California real estate prices pushed and pushed harder up the
hill from 1995 to 2005. This is too well known to recall here. Some reminders:
The median price for an existing, single-family house in California rose from
$237,060 in 2000 to $542,720 in 2005. That this was a mortgage bubble par
excellence, and not so much a housing bubble, can be seen in the evolution
of financing: Mortgages written in California responded to Bernanke's "zero-bound
policy" in spectacular form. Only 2% of home mortgages were of the non-principal
paying "interest-only" version in 2002. This rose to 47% in early 2004 and
to 67% by late 2004. In February 2012, the median price for an existing, single-family
house in California was $266,600, and falling at a 7% annual rate.

Doug Noland, author of the Prudent Bear's Credit Bubble Bulletin, wrote
untiringly during the boom years of the "moneyness of credit." (He still writes
every week and is still well worth reading.) Noland wrote that the Fed and
Wall Street refused to understand the explosion of credit and credit derivatives
were behaving like money and inflating house prices. This should have been
understood. It was the ability to buy (sort of) a house without showing up
with one penny at the closing that gave Sisyphus his third and fourth wind.

Bernanke has shown no understanding of either the quantity or the quality
of credit. Yet, he is 100% sure of his infallibility.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.